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New remedial action guidance for tax-advantaged bonds

The IRS recently issued Revenue Procedure 2018-26 to provide additional guidance on the type of remedial action that issuers of tax-advantaged bonds may take to preserve the status of such bonds upon the occurrence of “nonqualified uses” of bond proceeds.

On April 11, 2018, the Internal Revenue Service issued Revenue Procedure 2018-26 (“Rev. Proc. 2018-26”) to provide additional guidance[1] on the type of remedial action that issuers of tax-exempt bonds, tax credit bonds and direct-pay bonds[2] may take to preserve the tax-advantaged status of such bonds upon the occurrence of “nonqualified uses” of bond proceeds. Rev. Proc. 2018-26 (a) extends the application of certain existing remedial action rules to tax credit bonds and direct-pay bonds, (b) provides a new remedial action that may be taken in the case of certain eligible leases, and (c) provides an alternative remedial action for direct-pay bonds.

Certain tax-exempt bonds are subject to limitations on the amount of private business use of bond-financed property. Remedial action is necessary when an issuer (or a conduit borrower)[3] takes a “deliberate action” that changes the use or ownership of bond-financed property in a manner that causes the applicable private business use limit to be exceeded or, in the case of qualified 501(c)(3) bonds, violates the ownership requirement (collectively “changes in use”). Under Section 1.141-12 of the Treasury Regulations, in effect since 1997 (the “Remedial Action Regulations”), issuers that cause a change in use of bond-financed property have had three remedial action alternatives under which to preserve the tax exempt status of their bonds. Rev. Proc. 2018-26 makes certain modifications to these rules, including applying certain portions of the Remedial Action Regulations to tax credit bonds and direct-pay bonds.[4]

The Remedial Action Regulations provide for the following three remedial action options, each of which is subject to its own set of conditions and limitations. In order for an issuer to avail itself of one of these options, certain criteria must be satisfied, including that the issuer did not reasonably expect a change in use on the issue date of the bonds and that the terms of any arrangement giving rise to the change in use are bona fide and arm’s length, with the new user paying fair market value for its use of the financed property.

1. Redemption/defeasance option. Issuers may remediate a change in use by redeeming or defeasing[5] bonds corresponding to the nonqualified use within 90 days of the change in use[6] (the “Redemption/Defeasance Option”). The issuer must select bonds to be redeemed or defeased in a manner that does not extend the weighted average maturity of the bond issue.

For sales of bond-financed property for which the issuer is compensated exclusively in cash paid up-front (an “all-cash sale”), the issuer may, in some circumstances, be able to redeem or defease fewer bonds than otherwise would be required, based on the amount the issuer receives from the sale.

Under Rev. Proc. 2018-26, the Redemption/Defeasance Option is generally extended to tax credit bonds and direct-pay bonds.[7] Nonqualified uses of tax credit bonds and direct-pay bonds may include not only violations of use-of-proceeds requirements, but also the failure to spend proceeds within applicable time limits or on qualifying projects.

Further, while the Remedial Action Regulations previously required defeasance escrows to be invested at a yield not in excess of the yield on the bonds, Rev. Proc. 2018-26 allows issuers to instead make rebate payments on any excess earnings on a defeasance escrow established under the Redemption/Defeasance Option.

2. Alternative use of disposition proceeds option. In an all-cash sale of bond financed property, an issuer may remediate the change in use in certain circumstances by spending the cash sales proceeds on other qualifying capital improvements within two years of the deliberate action (the “Alternative Use of Disposition Proceeds Option”).[8] Under this option, issuers must reasonably expect to spend the disposition proceeds on eligible capital expenditures within two years of the change in use, and if any disposition proceeds remain unspent after two years, the issuer must use such amounts to redeem or defease bonds.

Under Rev. Proc. 2018-26, the Alternative Use of Disposition Proceeds Option is generally extended to tax credit bonds and direct-pay bonds.

3. Alternative use of facility option. An issuer may remediate a change in use in certain circumstances if the new use of the bond-financed facility qualifies for financing with tax-exempt bonds, e.g., use by a 501(c)(3) organization rather than a governmental unit (the “Alternative Use of Facility Option”).[9] Rev. Proc. 2018-26 extends the Alternative Use of Facility Option to tax credit bonds and direct-pay bonds with respect to violations of the private business use and ownership requirements, but does not extend the Alternative Use of Facility Option to tax credit bonds or direct-pay bonds with respect to other nonqualified uses.

New remedial action for long-term leases

Because leases typically do not generate up-front cash (and except in limited cases would not be considered sales), prior to Rev. Proc. 2018-26, an issuer that leased a bond-financed facility in a manner that exceeded the applicable private use limitation could not avail itself of the Alternative Use of Disposition Proceeds Option. Rev. Proc. 2018-26 allows for the Alternative Use of Disposition Proceeds Option, with certain modifications, to be used to remediate changes in use resulting from “eligible leases.” The most significant modification is that the issuer must treat funds in an amount equal to the present value of all lease payments required to be made under the lease (using the yield on the bond issue as the discount rate) as disposition proceeds. The issuer must reasonably expect to spend such funds on eligible capital improvements within two years from the start of the lease, and the issuer must use any remaining amounts to redeem or defease bonds. After the term of the lease ends, the original financed property, rather than the property financed with the “disposition proceeds” during the two-year spend-down period, will be treated as bond-financed, subject to the restrictions on private business use and ownership.

An eligible lease is a lease (i) the consideration for which consists exclusively of cash lease payments (irrespective of when paid) that are not financed with proceeds of an issue of tax-advantaged bonds, and (ii) that has a term at least equal to the lesser of 20 years or 75% of the average economic life of the leased property, determined at the start of the lease (or that otherwise runs through the end of the private use “measurement period,” which generally ends on the final maturity date of the bonds or the end of the expected economic life of the property, if earlier).

In certain instances, leases may be treated as a sales for federal income tax purposes of all or a portion of the underlying property. Further guidance may be required with respect to whether such leases will qualify for the new remedial action alternative.

New remedial action for direct-pay bonds — reduction in subsidy

Before the issuance of Rev. Proc. 2018-26, issuers of direct-pay bonds did not have an effective way of taking a remedial action to remediate a nonqualified use of the proceeds of such bonds. In addition to extending certain aspects of the Remedial Action Regulations to direct-pay bonds as described above, Rev. Proc. 2018-26 provides that an issuer of direct-pay bonds may remediate a nonqualified use by reducing the amount of the subsidy it claims going forward in an amount corresponding to the nonqualified use and notifying the Internal Revenue Service of the remedial action on Form 8038-CP, the form used to claim direct-pay bond subsidies. In addition to forgoing a portion of the subsidy, the issuer must treat any disposition proceeds as gross proceeds subject to the arbitrage rules (including rebate) and as proceeds for purposes of the applicable Internal Revenue Code section.

Effective date of Rev. Proc. 2018-26

Rev. Proc. 2018-26 applies to nonqualified uses that occur on and after April 11, 2018, but may also be applied to nonqualified uses that occur prior to April 11, 2018.

[1] This new guidance supplements current guidance contained in existing Treasury Regulations.

[2] Tax credit bonds are taxable bonds that provide a federal tax credit to the investor pursuant to Section 54A of the Internal Revenue Code or similar provisions, and direct-pay bonds are taxable bonds that provide a refundable federal tax credit payable to the issuer pursuant to Section 6431 of the Internal Revenue Code. Such bonds include Build America Bonds, new Clean Renewable Energy Bonds, Qualified Energy Conservation Bonds, Qualified Zone Academy Bonds, Qualified School Construction Bonds and Recovery Zone Economic Development Bonds.

[3]Although the term issuer will be used throughout this memorandum, the principles described in existing regulations and under Rev. Proc. 2018-26 also apply to actions taken by conduit borrowers.

[4] Until now, the Remedial Action Regulations, by their terms, applied only to changes in use with respect to tax exempt bonds and did not apply to tax credit bonds or direct-pay bonds.

[5] The defeasance option is available only if the first optional call date of the bonds is within 10.5 years of the issue date. Issuers utilizing the defeasance option must notify the Internal Revenue Service of the defeasance.

[6] The Redemption/Defeasance Option may also be used in certain instances to take “anticipatory remedial action,” i.e., remedial action prior to any change in use.

[7]Rev. Proc. 2018-26 provides that a defeasance that occurs pursuant to the terms of the original bonds will not trigger a “reissuance” of the bonds for tax purposes for either the issuer or the bondholders.

[8] If the disposition proceeds are to be used by a 501(c)(3) organization, the nonqualified bonds are treated as reissued for certain federal income tax purposes as of the date of the change in use.

[9] Under the Alternative Use of Facility Option, the nonqualified bonds are treated as reissued for certain federal income tax purposes as of the date of the change in use.

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